Page 698 - Krugmans Economics for AP Text Book_Neat

first; and the other companies would adopt similar prices. This pattern of behavior,
In price leadership, one firm sets its price
in which one company tacitly sets prices for the industry as a whole, is known as
first, and other firms then follow.
price leadership.
Firms that have a tacit understanding not to
Interestingly, firms that have a tacit agreement not to compete on price often en-
compete on price often engage in intense
gage in vigorous nonprice competition—adding new features to their products,
nonprice competition, using advertising
spending large sums on ads that proclaim the inferiority of their rivals’ offerings, and
and other means to try to increase their sales.
so on.
Perhaps the best way to understand the mix of cooperation and competition in
such industries is with a political analogy. During the long Cold War between the
United States and the Soviet Union, the two countries engaged in intense rivalry
for global influence. They not only provided financial and military aid to their
allies; they sometimes supported forces trying to overthrow governments allied
with their rival (as the Soviet Union did in Vietnam in the 1960s and early 1970s,
and as the United States did in Afghanistan from 1979 until the collapse of the
Soviet Union in 1991). They even sent their own soldiers to support allied govern-
ments against rebels (as the United States did in Vietnam and the Soviet Union
did in Afghanistan). But they did not get into direct military confrontations with
each other; open warfare between the two superpowers was regarded by both as too
dangerous—and tacitly avoided.
Price wars aren’t as serious as shooting wars, but the principle is the same.

How Important Is Oligopoly?

We have seen that, across industries, oligopoly is far more common than either per-
fect competition or monopoly. When we try to analyze oligopoly, the economist’s
usual way of thinking—asking how self-interested individuals would behave, then
analyzing their interaction—does not work as well as we might hope because we do
not know whether rival firms will engage in noncooperative behavior or manage to
engage in some kind of collusion. Given the prevalence of oligopoly, then, is the
analysis we developed in earlier modules, which was based on perfect competition,
still useful?
The conclusion of the great majority of economists is yes. For one thing, important
parts of the economy are fairly well described by perfect competition. And even though
many industries are oligopolistic, in many cases the limits to collusion keep prices rela-
tively close to marginal costs—in other words, the industry behaves “almost” as if it
were perfectly competitive.
It is also true that predictions from supply and demand
analysis are often valid for oligopolies. For example, we saw
that price controls will produce shortages. Strictly speaking,
this conclusion is certain only for perfectly competitive indus-
tries. But in the 1970s, when the U.S. government imposed
price controls on the definitely oligopolistic oil industry,
the result was indeed to produce shortages and lines at the
gas pumps.
So how important is it to take account of oligopoly? Most
economists adopt a pragmatic approach. As we have seen here,
the analysis of oligopoly is far more difficult and messy than
that of perfect competition; so in situations where they do
AP Photo not expect the complications associated with oligopoly to be
crucial, economists prefer to adopt the working assumption of
perfectly competitive markets. They always keep in mind the
Cars line up for gasoline in 1973 after the
U.S. government imposed price controls. possibility that oligopoly might be important; they recognize that there are impor-
tant issues, from antitrust policies to price wars, that make trying to understand oli-
gopolistic behavior crucial.

656 section 12 Market Structures: Imperfect Competition